What a life annuity is and how it works

What it is, exactly

A life annuity (renta vitalicia) is an insurance product, not a banking one. You hand a lump sum to an insurer — in one go or in contributions over time — and in exchange it guarantees to pay you a regular amount, normally monthly, from the age you have agreed until you die. Its purpose is to cover the drop in income that happens at retirement, when the state pension is smaller than the salary you were earning.

• It is a savings insurance policy, not a deposit or a fund
• You put in capital and get it back converted into a regular income
• It is paid until death, however long that takes

Immediate or deferred

There are two forms in Spain. With an immediate annuity you start drawing the month after you hand over the capital, and what you draw depends on your age, your estimated life expectancy and the amount contributed. With a deferred one you take it out today and set a future start date: someone of 50 can take one out and start drawing at 65. In both cases, once it starts, the income is paid until the holder dies.

• Immediate: you draw from the following month
• Deferred: you take it out now, you draw from the agreed date
• The amount depends on age, life expectancy and capital

The three surrender options, which is where the real decision is

This is the part that most shapes the outcome and is least explained. With capital ceded (capital cedido) you give up ever recovering the money: neither you nor your heirs get it back, not even on death — and in exchange the monthly income is the highest of the three. With capital reserved (capital reservado) you can cancel and recover the capital at any point, and your beneficiaries receive it if you die, but the income is noticeably lower. The mixed option sits in between: you can surrender at market value, and what your beneficiaries receive decreases over the years from the start of the contract.

• Capital ceded: highest income, never recovered
• Capital reserved: surrenderable, but lower income
• Mixed: surrenderable at market value, with decreasing capital

How it is taxed

This is its main attraction. Except when the money comes from pension plans or other products that gave tax relief at the time, the income is taxed in Spanish income tax (IRPF) as investment income — savings income — and not as earned income, which usually bears a higher rate. On top of that, not all the income you draw is taxed, only a percentage of it, and that percentage is lower the older you are when you set it up. That is why the product starts being tax-efficient from a certain age. The specific bands change with legislation: check them with the Agencia Tributaria or your tax adviser before doing any sums.

• Taxed as savings income, not earned income
• Only part of the income is taxed, less the older you are
• If it comes from a pension plan, the treatment is different

What happens to your estate

A life annuity is not a perpetual income: it ends when the holder dies and, by default, does not form part of the inheritable estate. That said, the contract allows clauses that do bring it into the estate. It can be taken out with two holders, so that when one dies the other keeps drawing the full income. And third-party beneficiaries can be named, who will receive the capital as a single payment or as an income. In both cases, what they receive is taxed under inheritance and gift tax (Impuesto sobre Sucesiones y Donaciones), not income tax.

• By default it ends with the holder
• With two holders, the survivor keeps drawing
• What the heirs receive goes through inheritance and gift tax

What the brochure usually leaves out

Three things. The first, and the most important: life annuities are not covered by the Fondo de Garantía de Depósitos, the Spanish deposit guarantee fund, because they are not a banking product. They fall under the Dirección General de Seguros y Fondos de Pensiones, and if the insurer fails it is the Consorcio de Compensación de Seguros that steps in. It is a different protection, with its own rules. The second: being a savings rather than a risk insurance product, the interest it offers is limited — you are trading return for certainty. And the third: depending on the option you choose you can end up with no access to your money, a cost you do not see until you need it.

• Not covered by the deposit guarantee fund, but by the Consorcio
• Limited return: you are paying for the security
• Liquidity depends entirely on the option you take out

When it fits and when it does not

It fits a fairly specific profile: someone close to retirement or already retired, with capital already built up, who values having a guaranteed income for life above return and above access to the money. Whoever accepts that trade is buying, above all, the certainty that the money will not run out if they live a long time — that risk is taken on by the insurer. It does not fit if you are still in the accumulation phase, if you might need that money, if you do not have your emergency fund in place or if return is your priority. And in no case is it a decision to be taken with one provider's brochure in front of you.

• Fits: capital already built and certainty as the priority
• Does not fit: still accumulating, or with that liquidity committed
• Always compare more than one provider before signing

Frequently asked questions